In 2008, the financial world was at the verge to collapse. Right then, an (old) idea of digital cash was picked up and developed further. On October 31, 2009, someone (or a group of people) under the pseudonym Satoshi Nakamoto posted a white paper entitled "Bitcoin: A Peer-to-Peer Electronic Cash System" to a cryptography mailing list. Briefly thereafter, Nakamoto published the first release of Bitcoin (BTC) as open source software.
In the years to follow, Bitcoin not only started to establish itself as a digital payment system allowing global payments to be much cheaper and faster than what was offered by banks but gained in value rapidly, too. However, the path that the value of BTC took was very volatile as the following figure shows. This Blogpost explains why bitcoin has been so volatile.
Figure 1 - BTC price since 2014 (source Coindesk)
The evolution of the price of BTC is impressive. From almost nothing it was shooting up to 20`000 $ in 2017, followed by a crash down to 3`000 $ in 2019 and a rebound to 10`000 $ with another downwards movement to 6000 $. Putting this into numbers, the annualized return on BTC was 70% while the volatility of the return was also 70%. The meaning of these statistical numbers is that in 2 out of three years one did find the return between 0% and 140%. And in 4 out of 5 years the return was be between -70% and +210%. It is instructive to compare these numbers with assets like bonds and equities as well as with commodities like Gold or currencies like the Turkish Lira. In the same time period the volatility of the world equity index was 11%, the world bond market had a volatility of only 2.25% and the volatility of Gold was 12.53%. Finally, the volatility of the Turkish Lira was 20%. Thus indeed bitcoin was much more volatile than other assets. How come?
Finance has developed a few theories how to price assets. Once a theory is established, the volatility of prices goes down. A nice instance of this claim was the introduction of the Black and Scholes Theory to price options in the 1970ties after which options traded exactly at the theoretical prices. Thus to understand the volatility of bitcoin one has to understand why standard theories do not apply. The simplest theory is that markets do not allow for arbitrage, i.e. one cannot combine assets in a trading strategy that yields a high return without taking any risk. Such arbitrage opportunities would easily be spotted by traders and quickly be erased by taking opportunity thereof. With this fundamental idea one can determine the price of riskless bonds as the discounted sum of its future cash flows, where the discount rate is the risk-free rate. If the price were lower than the discounted sum of future cash flows one could borrow money at the risk free rate and buy the bond. In the future one would then repay the debt from the cash flows of the bond. If the price of the bond were higher one would sell the bond and invest the proceeds into a deposit earning the risk free rate. In both cases one can make money from nothing. Thus, prices of bonds should be equal to the discounted sum of their future cash flows. Since this argument is compelling volatility of bond prices can only arise from changes in the risk free rate. Thus as we have seen above the volatility of bonds is the smallest. The volatility of equities is higher than that of bonds because they have a second source of uncertainty. Besides fluctuations in the risk free rate the cash flows from equites, i.e. dividends and buy backs, are uncertain – bringing us from 2.25% to 11% volatility. However, there are also assets without any cash flows, like for example Gold. Then arbitrage valuations can no longer be made and one has to guess the fluctuations in demand and supply. Many analysts study the demand and supply of commodities like Gold or Oil so that with a long history of events, fluctuations in prices can be guessed quite accurately – resulting in a modest volatility of 12.53%. Also, finance theory has found models to price currencies that are issued by nations, like the Swiss Franc, the Pound or the Turkish Lira. The idea to price currencies is again based on arbitrage. Suppose you could borrow money at 1% in Switzerland and invest it in a Turkish Government Bond yielding 11% then you can make a risk-free profit if the Turkish Lira does not depreciate towards the Swiss Franc by more than 10%. Thus, one should expect that the interest rate differential is counteracted by an adverse exchange rate move. This yields a theory (uncoverd interest rate parity, UIP) determining the returns one could expect from investments into currencies. And as the volatility of 20% on the Turkish Lira exchange rate to the US-Dollar shows even with many surprises coming from politics the theory works quite well. For more stable countries like Germany, Switzerland, the UK and the USA the market prices are set exactly according to the UIP. That is to say when a Swiss investors holds an asset denominated in US-Dollars he can hedge the exchange rate risk by paying the interest rate differential between the US and Switzerland. Thus we again see the general rule: if there is a theory that suggests how to price an asset, market prices are less volatile because most market participants will apply the theory in their calculus. Thus to understand the volatility of bitcoin one has to understand which asset pricing theory could apply.
The rational pricing of bitcoin is a challenge for asset pricing theories. Bitcoin has no cash flows so that arbitrage ideas like those applied to bonds and equites do not help to bound prices. Also, bitcoin is no national currency in which bonds are denominated like the Swiss Franc, the Euro, the Dollar or the Turkish Lira. So ideas like the uncovered interest rate parity cannot be applied. Bitcoin is more like Gold, i.e. a commodity in limited supply that can be used for transactions. Since the supply of Bitcoin is steady and predictable, the task to price bitcoin is to have good guesses on the demand of bitcoin. Unfortunately, bitcoin is not only used to transact but also to speculate, i.e. to hold it hoping for price increases. Run-ups like those in 2017 are clear indicators of a speculative bubble that have been witnessed manifold before: The Tulip Bubble 1634-1637, , the South Sea Bubble 1710-1720, the Mississippi Bubble 1717-1720, the Railway Bubbles in the 19th century, the US Equity Bubbly 1920-1929, the dot.com Bubble 1995-2001, the US Housing Bubble 2003-2007etc. Technological disruptions like the blockchain typically provide the ground for speculative bubbles. Once speculators have burned their fingers times become calmer and the innovation is priced more rationally, reducing the volatility of the prices. Thus the extremely high volatility of Bitcoin that we witnessed so far will eventually pass away and bitcoin will find its place as a reliable asset in investors` portfolio of cash holdings, bonds, equities and commodities.